Robo-Advisers: Best Deck Chairs on the Titanic?

Much has been written recently about robo-advisers, including the perceived threat to traditional investment advisers. Robo-advisers do provide an opportunity for investors to receive asset management services, investors whose assets would not meet the high minimum requirements often charged by many investment advisers.

However, it is important for investors to realize the potential issues with the limited services currently provided by robo-advisers. Robo-advisers currently provide asset management services on a reactive basis, as opposed to a proactive basis. As a result, the risk management protection offered by robo-advisers is very poor.

Many of the current robo-advisers offer automatic rebalancing services, which automatically an investor’s portfolio allocations to their original percentages once certain thresholds are breached. The rebalancing takes place without regard to factors such as overall economic and/or stock market conditions.

And therein lies the potential threat to an investor’s financial well-being, and the opportunity for traditional investment advisers to establish their value proposition to investors. By being proactive and recognizing the potential threats posed by existing economic and/or stock market conditions, an alert investment adviser can use various hedging strategies to protect their clients against significant financial losses.

There are those who will quickly counter that such strategies are nothing more than market timing and that market timing does not work. My first responds to such a response is that even rebalancing is market timing if market timing is defined as any reallocation of an investor’s resources.

My second response is that an investment adviser, as a fiduciary, has a legal obligation to consider appropriate hedging strategies to protect a client’s financial security. Support for that position coms from the famous case of Levy v. Bessemer Trust (Levy v. Bessemer Trust Co., N.A., No. 97 Civ. 1785, 1999 WL 199027 (S.D.N.Y. Apr. 8, 1999).

Levy involved a situation where Levy had a investment portfolio that was heavily concentrated in one stock. When Levy inquired about potential ways to protect against a significant financial loss due to a drop in the stock’s price, he was not informed about potential hedging techniques, in this case the use of protective puts. The court ruled that Bessemer breached its fiduciary duty by failing to inform Levy of such strategies and discuss same.

Even where an investment adviser has discretionary power over an account, I generally urge my advisory clients to meet with a client and discuss potential hedging strategies when appropriate and document the meeting with a follow-up letter. The client meeting allows an adviser to avoid potential he said-she said situations. Since  hedging strategies usually involve financial costs, the meeting, and follow-up letter, help avoid controversies involving such costs.

The robo-adviser contracts I have seen clearly limit their actual wealth management services to rebalancing. Therefore, robo-advisers would not be liable for losses sustained by their investors due to a lack of proactive wealth preservation strategies, such as asset reallocation or protective puts. I’m not sure investors using robo-advisers are aware of this fact and the potential losses that may result. Prudent investment advisers can seize the opportunity and reinforce the value of their services in protecting against unnecessary and significant financial losses.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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